This paper argues theoretically the impact of expected indirect bankruptcy costs on optimal capital structure in the Tax Shield-Bankruptcy Cost (TS-BC) framework. By relaxing assumptions of Modigliani and Miller (1958,1963) to incorporate bankruptcy costs into capital structure policy making, we argue that expected indirect bankruptcy costs caused by higher financial risk increase a leveraged firm's business risk, thus increase its cost of capital. Based on the notion that the optimal capital structure can be determined by comparing the marginal tax shield with marginal bankruptcy probability based on binomial multiple logit model and the residual market value of the firm in period one. Future empirical evidence is needed to support this model.
Department, Program, or Center
Advances in Investment Analysis and Portfolio Management. 2005. 1 (2005). 235-237.
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